Unit 5

Meaning of Dividend

Dividend refers to the business concerns net profits distributed among the shareholders. It may also be
termed as the part of the profit of a business concern, which is distributed among its shareholders.

According to the Institute of Chartered Accountant of India, dividend is defined as “a distribution to

TYPES OF DIVIDEND/FORM OF DIVIDEND

Dividends may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are
classified into:

A. Cash dividend

B. Stock dividend

C. Bond dividend

D. Property dividend

Cash Dividend

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common
and popular types followed by majority of the business concerns.

Stock Dividend

Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type,
cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the
existing shareholders of the business concern.

Bond Dividend

Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash
dividend, the company promises to pay the shareholder at a future specific date with the help of issue of
bond or notes.

Property Dividend

Property dividends are paid in the form of some assets other than cash. It will distributed under the
exceptional circumstance. This type of dividend is not published in India.

DIVIDEND DECISION

Dividend decision of the business concern is one of the crucial parts of the financial manager, because it
determines the amount of profit to be distributed among shareholders and amount of profit to be treated
as retained earnings for financing its long term growth. Hence, dividend decision plays very important part
in the financial management. Dividend decision consists of two important concepts which are based on the
relationship between dividend decision and value of the firm.

FACTORS DETERMINING DIVIDEND POLICY

Profitable Position of the Firm Dividend decision depends on the profitable position of the business
concern. When the firm earns more profit, they can distribute more dividends to the shareholders.
Uncertainty of Future Income

Future income is a very important factor, which affects the dividend policy. When the shareholder needs
regular income, the firm should maintain regular dividend policy.

Legal Constraints

The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends.
Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.

Liquidity Position

Liquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms
can provide cash dividend otherwise, they have to pay stock dividend.

Sources of Finance

If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for retained
earnings. Growth Rate of the Firm High growth rate implies that the firm can distribute more dividend to its
shareholders.

Tax Policy

Tax policy of the government also affects the dividend policy of the firm. When the government gives tax
incentives, the company pays more dividend.

Capital Market Conditions

Due to the capital market conditions, dividend policy may be affected. If the capital marketis prefect, it
leads to improve the higher dividend.

Irrelevance of Dividend

According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of
the company. There is no relation between the dividend rate and value of the firm. Dividend decision is
irrelevant of the value of the firm. Modigliani and Miller contributed a major approach to prove the
irrelevance dividend concept.

Modigliani and Miller’s Approach

According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it
does not affect the value of the firm. “Under conditions of perfect market, rational investors, absence of tax
discrimination between dividend income and capital appreciation, given the firm’s investment policy, its
dividend policy may have no influence on the market price of shares”.

Assumptions

MM approach is based on the following important assumptions:

1. Perfect capital market.

2. Investors are rational.

3. There are no tax.

4. The firm has fixed investment policy.

5. No risk or uncertainty
Exercise

From the following information supplied to you, ascertain whether the firm is following an optional
dividend policy as per Walter’s Model?

Total Earnings Rs. 2,00,000

No. of equity shares (of Rs. 100 each 20,000)

Dividend paid Rs. 1,00,000

P/E Ratio 10

Return Investment 15%

The firm is expected to maintain its rate on return on fresh investments. Also find out what should be the
E/P ratio at which the dividend policy will have no effect on the value of the share? Will your decision
change if the P/E ratio is 7.25 and interest of 10%?
r >Ke therefore by distributing 60% of earnings, the firm is not following an optional dividend policy. In this
case, the optional dividend policy for the firm would be to pay zero dividend and the Market Price would
be:
Types of dividend policy:

Dividend policy depends upon the nature of the firm, type of shareholder, and profitable position. Based
on the dividend declaration by the firm, the dividend policy may be classified under the following types:
• Regular dividend policy

• Stable dividend policy

• Irregular dividend policy

• No dividend policy.

Regular Dividend Policy

A dividend payable at the usual rate is called a regular dividend policy. This type of policy is suitable for
small investors, retired persons, and others.

Stable Dividend Policy

A Stable dividend policy means payment of a certain minimum amount of dividend regularly. This dividend
policy consists of the following three important forms:

• Constant dividend per share

• Constant payout ratio

• Stable rupee dividend plus extra dividend

Irregular Dividend Policy

When the companies are facing constraints of earnings and unsuccessful business operations, they may
follow an irregular dividend policy. It is one of the temporary arrangements to meet the financial problems.
These types have adequate profit. For others, no dividend is distributed.

No Dividend Policy

Sometimes the company may follow a no dividend policy because of its unfavorable working capital position
of the amount required for future growth of the concerns.